How to perform a stock analysis (Basics Part 1):
There are incredibly different approaches to gauging where a stock should be priced. There are two main categories however: Fundamental and Technical analysis. Fundamental is looking at the merits of the company itself based upon information found in SEC filings (where managers talk about what their company is about, financial strengths and weaknesses, competitors, future directions of the company) and various financial reports (the balance sheet, cash flow statement and income statement). One mostly looks to decide if the direction, management, and financial strength of a company are sound. Other areas to look at would be competition, possible barriers to entry and possible expansion opportunities. Meanwhile, technical analysis is looking at various graphs and relying on possible recurring trends in market activity to predict where the stock will go: MACD (Moving averages), volumes, and looking for formations like the heads and shoulders are common Technical analysis tools. Most investors will use a combination of both in order to decide when and where to enter the market.
To further explain how to find the theoretic value of a share of stock, we would have to explore how stock prices tie company operations and investors’ capital together. Investors are people who give a company capital in return for a share of the profits. Imagine a bank where you lend the bank money (aka deposit) and get a varying amount of interest (if the company does well, you get bigger payouts for your investment and vice versa). The company’s board of directors (who are placed there by the shareholders) decide how much of the profits gets paid out as dividends and how much will be kept in order to have capital to pay for future business transactions (buying machines, factories, expanding, acquiring other companies). The latter is known as retained earnings. This money is considered stockholder equity and is still owed to the investors, though it has now been reinvested by the company. Since the company now has either more physical assets or cash, the company is worth more now. While this might intuitively make sense, (if something has more in assets, it should be worth more) how are these investors going to get their money back? Stocks don’t bring happiness like a happy meal would and if they don’t pay dividends, then why are you willing to pay $10 if they will never give you a dime of their profits (unless there’s a fool who’s willing to buy the share from you for more)? Two reasons:
1: the value of the company will one day be paid out in full to its investors: Many companies pay no dividends and yet are worth a large amount (Berkshire Hathaway has never paid a dividend yet is about $90,000/share). An example that demonstrates this entire point can be seen in a company whose shares are worth $1 and who have 1000 shares outstanding but pays no dividends. People are willing to pay the $1 because their money will be returned to them at some point in the future when it: 1. gets acquired by another company (example is Dainippon buying Sepracor for 2.6 billion and paying its investors premium ontop of their share price) 2. The company closes its doors and just pays out all the money it owes to its investors. If the company gets acquired/closes in 15 years, my ROE is the interest rate needed to turn the amount of money I paid for a share of stock when I first bought it into the amount of money that was finally paid out for 1 share of stock.
2: if stock prices stayed the same, there would be a greater return on equity (if stock price is $10, there are 100 shares, and the company makes $200 in profits, ROE = (200/100)/10 = 20%...if profits become $400, then ROE is now 40%). But, since everybody is looking for higher ROE (ie, how much money they get from investing $1) then the price of the stock will be bid up until it reaches equilibrium again, thus dropping ROE again.
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